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Are Different National Stock Markets Driven by the Same Stochastic Hidden Variable?

Keywords: regime switching , portfolio management , international investing , predictability , stock markets

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Abstract:

The following contribution analyzes linkages between preselected national stockmarkets by a multivariate application of Markov-Switching models. This study shows evidencethat the US-stock market and the German and Swedish stock markets are driven bythe same unobservable stochastic variable. The latent variable causes these stock markets toswitch between highly persistent Bull- and Bear-market regimes which offer strategic markettiming opportunities. An out-of-sample experiment where stock market regimes are simultaneouslyforecasted on a monthly frequency (January 2008 — December 2010) shows thatan actively managed equity funds being restricted to hold stocks permanently, dominates allpassive trading strategies that account for internationally diversified equity portfolios.

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